George Bush’s recently announced fiscal package has several warnings for the Indian economy, writes Alok Ray

Dangers ahead

President George W. Bush has unveiled his much-awaited stimulus package for the economy of the United States of America. The cornerstones of this package are the abolition of tax on dividend income and across-the board lowering of income tax rates.

There are several reasons why India should bother about this. First, the US, whether we like it or not, is the principal engine of growth for the world economy. This is more so as there are no signs that Japan, on its own, would come out of its decade-old recession soon. Europe is going through an economic slowdown with Germany, the leading European economy, in trouble. So, whether the US economy will be in for a recovery is a matter of serious global concern.

Second, the abolition of dividend tax and an effective lowering of tax rates by increasing the exemption limit have been recommended by the Kelkar committee, too, in India. It is likely to be implemented in the coming budget, unlike the committee’s other politically unpopular proposals. The Bush fiscal policy package has been highly controversial in the US. Thus it is important to understand the debate surrounding this policy for our own budget exercise in February.

Take the dividend tax issue. A standard argument against dividend tax is that it involves double taxation. The company first pays tax on the pre-tax profits and the same income is taxed again when the person receiving the dividend has to pay the dividend tax. But this is not a water-tight argument. The same rupee is taxed twice when a person pays income tax on his salary and then pays sales tax on purchases made with his after-tax income. The double-taxation argument should apply here too and it is not restricted to only dividend income. That is why, the double-taxation argument notwithstanding, some countries (like many Scandinavian countries) have dividend tax while others do not.

In the US and in India, an additional argument is being currently used. In the prevailing recessionary conditions, it is argued that the abolition of dividend tax would attract investment in the stock market and would help economic recovery. With higher post-tax returns on investment in company shares, people may, indeed, invest more in stocks and less in bank deposits. But this does not necessarily mean that more funds will go into new stocks. More investment in secondary stock markets does not guarantee new investment in industrial capacity or fuller utilization of existing capacity. Businessmen would invest in new capacity creation only if they expect a significant rise in demand for their products. Hence, generation of demand from consumers for consumer goods or from business people for machinery and capital goods is necessary. Abolition of dividend tax may not help either of these under the prevailing excess capacity situation.

P. Chidambaram, the then finance minister, abolished dividend tax in the hands of the investor a few years back. His argument was basically administrative simplicity. He enacted a uniform 10 per cent tax deduction from the companies on dividend distribution but no tax on dividend in the hands of investors. This would save investors the hassle of getting tax refunds in many cases. Moreover, it would plug tax evasion by investors by basically having tax deducted at source from the companies. Yashwant Sinha reversed this by arguing that it is inequitable. Why should a rich investor pay the same 10 per cent uniform tax on dividend income, especially when many salary earners are paying 30 per cent marginal tax on salary income' So, administrative simplicity was sacrificed for equity and presumably higher revenue collection, though the exact calculations are never made very clear. In the coming budget, an about-turn towards the Chidambaram days would probably be made.

Now consider the proposal of reduction in tax rates. It was argued, specially by the so-called supply-side economists during the Thatcher-Reagan era, that a reduction in tax rates on individuals and companies would stimulate growth to such an extent that total tax collection would go up even at lower tax rates. This came to be known as the Laffer-curve. Many economists believe that a lowering of tax rates from a very high base may indeed increase greater tax compliance and hence higher tax collection. But there is no evidence that a lowering of tax rates, when the rates are moderate to start with, (like around 30 per cent as at present) would increase tax collection on its own.

As regards stimulating expenditure by leaving more after-tax income in the hands of the taxpayer, the important consideration is how much of the extra money the taxpayer is going to spend. Here, a selective tax cut for the relatively poor people, as against an across-the-board tax cut should be more effective as poor people spend a higher fraction of any increase in income. Many respected US economists agree that the Bush proposals would largely benefit the rich people and they are less likely to spend the tax bonanza. So no significant immediate economic stimulus can be expected from these initiatives. In fact, the Bush tax cuts would turn Bill Clinton’s projected cumulative budget surplus of $ 5.6 trillion over 2002-11 into a deficit of $ 1.5 trillion, not counting the impact of a possible war with Iraq. This is going to jeopardize the social security retirement programme and medical benefits for the poor and elderly. If this is the effect on an economy like the US’s, one can well imagine the consequences of an across-the-board tax cut in India, since the abolition of deductions and tax exemptions are least likely to be implemented.

Whatever be the tax rates or the status of exemptions, the salaried people in India have a lingering grudge. They feel that the burden of direct taxes falls almost solely on them while others earning much more do not pay any income tax. Factually, this is not quite true. Only 35 per cent of the personal tax revenues are contributed by the salaried taxpayers while the rest is contributed by the self-employed. Even then there is a big element of truth in what the salaried people complain about. It is often the case that the fairly rich self-employed doctors and lawyers can and do hide a lot of their income. They declare only a small part of their true income in their tax returns and pay taxes only on that portion. The salaried people cannot do it simply because for them the taxes are deducted at source and there is no way by which they can under-report their income.

One final question. The US Central Bank under Greenspan has cut interest rates 12 times in the last 2 years and US short term interest rate is at 1.25 per cent — the lowest level for more than 40 years. But recovery is nowhere to be seen. Many economists feel that monetary policy has lost its effectiveness — something which John Maynard Keynes predicted may happen in a deep recession. The Keynesian solution was to create a budget deficit by cutting taxes and increasing government expenditure. Is it not what Bush is trying to do'

Again, many economists are sceptical. They feel that the major beneficiaries of the Bush budget deficit package would be rich people who would mostly save, not spend, the extra income in their hands and hence would not boost immediate demand. Moreover, the expansionary impact of the tax cuts (remember these are permanent tax cuts) may come at a later point when the economy may have already come out of recession on its own. In that case, it would fuel inflation. It would be politically difficult to raise taxes again even if that is needed for the economic health of the nation. Our budget-makers, too, need to be aware of these dangers.